FX Strategy: Euro Corrections To Be Short-Lived, Euro Gains To Continue‏

January and the first day of February were quite extraordinary for the euro. During this period the euro gained against all of the 32 biggest currencies in the world. The euro gains seen this year mean that we have now reached most of our otherwise euro positive forecast targets against majors, published on 15 January. We argue that further euro gains against GBP, JPY and USD are to be expected in Q1 and Q2. We will as usual publish official updated FX Forecasts on 15 February.

Factors behind the euro performance this year

1. Tail-risk attached to the euro has fallen further this year as Spanish and Italian yields have continued to drop. Safe haven flows out of the eurozone have therefore come to a halt and have most likely now reversed. This is probably also the reason why the ‘2012 safe havens’ like AUD, CAD and NOK have had a hard time performing this year despite support from risk and the cyclical outlook.

2. The market was caught short the euro when euro optimism returned with a vengeance (see e.g. the latest IMM update here).

3. European money market rates have risen quite significantly since the ECB first ruled out a rate cut on 9 January and as European banks repaid EUR137bn in the first LTRO repayment at the end of January. This year alone two-year EUR swap rates are close to 30bp higher.

4. The global recovery has continued and global/European PMIs have improved. The euro normally performs well in a cyclical recovery, whereas defensive currencies like USD, GBP and JPY tend to underperform.

5. Other major central banks have continued to favour a historical loose monetary policy. The Fed has said that a ‘substantial improvement’ in the labour market has not yet been seen (i.e. ‘open-ended easing’ will continue), the Bank of Japan has introduced a 2% inflation target, and Mark Carney, the incoming Bank of England governor, has been talking about nominal GDP targeting. Hence, the ECB is the odd one out as money market rates have been ‘allowed’ to crawl significantly higher this year.

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